Chapter 5: The Most Important Thing is.. Understanding Risk

Because none of us can know the future with certainty, risk is inescapable.

You’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

Risk is a bad thing, and most level-headed people want to avoid or minimize it.

An investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.

When you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.

Going beyond determining whether he or she can bear the absolute amount of risk that is attendant, the investor’s second job is to determine whether the return on a given investment justifies taking the risk.

When you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well.

If riskier investments reliably produced higher returns, they wouldn’t be riskier!

Riskier investments involve greater uncertainty regarding the outcome, as well as the increased likelihood of some painful ones. Riskier investments are those for which the outcome is less certain.

Many econnomists thing that risk equals volatility, because volatility indicates the unreliability of an investment. Marks’ takes great issue with this definition of risk.

It’s hard to believe volatility is the risk investors factor in when setting prices and prospective returns. People decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return.

The possibility of permanent loss is the risk Marks worries about, Oaktree worries about and every practical investor he know worries about.

But there are many other kinds of risk, and you should be conscious of them, because they can either (a) affect you or (b) affect others and thus present you with opportunities for profit. These include:

Falling short of one’s goal: Investors have differing needs, and for each investor the failure to meet those needs poses a risk. A given investment may be risky in this regard for some people but riskless for others. Thus this cannot be the risk for which “the market” demands compensation in the form of higher prospective returns.

Underperformance: Since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up.

Career risk: This is the extreme form of underperformance risk: the risk that arises when the people who manage money and the people whose money it is are different people. Risk that could jeopardize return to an agent’s firing point is rarely worth taking.

Unconventionality: The possibility that unconventional actions will prove unsuccessful and get them fired. … Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.

Illiquidity: for this investor, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk.

What gives rise to the risk of loss?

Risk of loss does not necessarily stem from weak fundamentals.

Risk can be present even without weakness in the macroenvironment. Mostly it comes down to psychology that’s too positive and thus prices that are too high. Fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.

The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all—what I call the improbable disaster—means it can seem safer than it really is.

The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable. If the risk of loss can’t be measured, quantified or even observed—and if it’s consigned to subjectivity—how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value.

Because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

The fact that something—in this case, loss—happened doesn’t mean it was bound to happen, and the fact that something didn’t happen doesn’t mean it was unlikely.

Taleb talks about the “alternative histories” that could have unfolded but didn’t. How often in the investing business are people right for the wrong reason? These are the people Nassim Nicholas Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors.

With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)?

We can’t know which of the possibilities will occur, and this uncertainty contributes to the challenge of investing. “Single-scenario” investors ignore this fact, oversimplify the task, and need fortuitous outcomes to produce good results.

While clearly it’s impossible to “know” anything about the future. If we’re farsighted we can have an idea of the range of future outcomes and their relative likelihood of occurring—that is, we can fashion a rough probability distribution. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

One thing to keep in mind is that the correlation of these improbable occurrences can affect many of your investments at the same time.

We have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

Here’s the key to understanding risk: it’s largely a matter of opinion. It’s hard to be definitive about risk, even after the fact.

Investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.Return has to be evaluated relative to the amount of risk taken to achieve it.

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured.

Investment risk is largely invisible before the fact—except perhaps to people with unusual insight—and even after an investment has been exited. Risk exists only in the future, and it’s impossible to know for sure what the future holds.

Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, However, occasionally, the improbable does occur.

People usually expect the future to be like the past and underestimate the potential for change.

We hear a lot about “worst-case” projections, but they often turn out not to be negative enough.

Risk shows up lumpily.

People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation.

Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.

Chapter 6: The Most Important Thing is…. Recognizing Risk

Great investing requires both generating returns and controlling risk.

High risk, comes primarily with high prices

Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk.

The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. High price both increases risk and lowers returns.

Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.

When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so … and risk compensation will disappear. So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether.

“There are few things as risky as the widespread belief that there’s no risk.”

Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

The degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

The market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more risk that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. Marks’ calls this the “perversity of risk.”

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.

Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

Chapter 7: The Most Important Thing is….Controlling Risk

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard.

Great investors are those who take risks that are less than commensurate with the returns they earn.

Loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. The fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though—as things turned out—it wasn’t needed at that time.

Risk control is invisible in good times but still essential, since good times can so easily turn into bad times. It’s an outstanding accomplishment to achieve the same return as the risk bearers and do so with less risk. Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

Risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so.

Important distinction between risk control and risk avoidance. Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Don’t run from risk. Welcome it at the right time, in the right instances, and at the right price.

It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.